Tax relief does not encourage pension saving

Pensions tax relief does little to encourage pension saving, particularly among low and medium earners, according to a report by the Pensions Policy Institute (PPI).

The report, Tax relief for pension saving in the UK, which has been sponsored by Age UK, the Institute and Faculty of Actuaries, Partnership and the Trades Union Congress (TUC), assesses the extent to which pension tax relief meets its objective of incentivising pension saving, and analyses options for reform.

The report found that the current pension tax relief system is tax-advantaged compared to other savings such as independent savings accounts (ISAs), with the tax-free lump sum of up to 25% of the pension being particularly valuable.

Employees who pay higher rate tax when working, and so get tax relief at the higher rate, but who pay basic-rate tax in retirement, get an even larger benefit.

“However, despite tax relief on contributions costing up to £35 billion a year after allowing for the introduction of automatic enrolment, tax relief is poorly understood and there is little evidence that it encourages pension saving among low and medium earners.

“The current system of pension tax relief favours higher and additional rate taxpayers. Even with pension saving boosted for lower earners by automatic enrolment, basic-rate taxpayers are estimated to make 50% of pension contributions, but receive only 30% of pension tax relief on contributions.

“Pension tax relief on lump sums, at an estimated cost of £4 billion a year, is similarly uneven. While only 2% of lump sums are worth £150,000 or more, they attract almost one-third of tax relief on lump sums.

“While recent reforms have reduced the cost of tax relief, they have not increased the value of saving for any individuals. More radical alternatives, such as a single rate of tax relief applied to all pension contributions, could spread the advantages of tax relief more evenly.

“A tax relief rate of 30% could have a cost similar to the current system. If presented clearly, a 30% rate could give a larger incentive to basic rate taxpayers to save, while still leaving pension saving at least tax neutral for higher rate taxpayers.

“But implementation of a single rate of tax relief would be far from straightforward, with significant changes in the administration of pension contributions required.

“The resulting tax charges could be very difficult to understand and lead to changes in behaviour by employees and employers.”

It would be surprising if, on the back of auto-enrolment and the potential large increases in pension savers, the Treasury didn’t want to look hard at the rising cost of tax relief and review the current arrangements in force from a ‘value for money’ point of view.

This report from the PPI is therefore very timely and is likely to be scrutinised closely both within government and across the pension and savings industry more widely.

It would be a massive mistake, in my view, to make any further major cut-backs on overall pension tax relief beyond those already made in recent times, for example to the annual and lifetime allowances. The reverberations from the infamous Gordon Brown raid on pension funds in 1997 are still with us and have undoubtedly played a part in the subsequent decline in final salary scheme provision, if not in pension saving more widely.

That said, it is true that at the individual-level pension tax relief is poorly understood by savers. We need a simpler and more transparent system to get across the value of the relief being provided. All payments made into a workplace pension plan, for example, need to spell out to the contributor how much extra is being put in by both the employer and the government on their behalf.

It has to be acknowledged that pension tax relief does tend to favour higher-rate tax payers who benefit most from the £35 billion currently paid out. There may be a case for standardising the level at a single rate of around 30% and capping the tax-free lump sum people can take at retirement at a reasonably high level, but great care needs to be taken on possible impacts and consequences.

However, any pressure to scrap the tax-free lump sum altogether should be strongly resisted. It would be madness to do so. To many people entering retirement with outstanding debts this is an important and necessary part of their pension plan and its future eradication could adversely affect many individuals’ attitudes towards pensions as an appropriate vehicle for their savings.

The PPI report is a useful analysis of the tax treatment of pensions. However, for many people the amount of money which they choose to put into pensions has got less to do with the tax rates and more to do with how much they can afford to save. Any changes to the tax-relief rates in the midst of auto-enrolment would probably do more harm than good.